Thinking Things Over May 28, 2012

Volume II, Number 21: Remembering Milton Friedman in the Torpor of 1980

By John L. Chapman, Ph.D. Washington, D.C.

Amidst continuing nervousness about the Eurozone and slower global growth, political debate in the U.S. is centered around the best path forward to return to sustainable prosperity. The Wall Street Journal reminded us this past weekend of similar tough times 32 years ago, and the group of economic advisors led by 1976 Nobel Laureate Milton Friedman who steeled a new President’s nerves to “stay the course” on a pro-growth and pro-investment policy mix — exactly what needs to happen again today.

The Global Backdrop Compared to 1980

This past week the continuing stream of data about the global economy was not good around the globe but, we hasten to add, “not bad” for the United States. Manufacturing is contracting in the Eurozone and in China (for the seventh straight month in the latter), and slowing in the U.S., along with orders for durable goods including aircraft, computers, and heavy machinery (though still all positive growth here). Both the OECD and IMF have cut their 2012 forecast for global growth, now below the 3.9% seen in 2011. The Morgan Stanley MSCI Index for global equities is off 9% since mid-March, and the price of crude oil, the leading globally-traded industrial commodity – and hence indicator of commercial appetites – is down 15% since the beginning of May alone. Worries about Greece and its possible-to-likely exit (or forced eviction) from the Eurozone after its June 17 elections have only added to investor nervousness on a global scale: Greece is of course a small country, but its Euro-exit and debt repudiation could be a harbinger for the other heavily-indebted member states in the Eurozone, beginning with the 4th largest economy in the union, Spain, whose banking system is increasingly stressed.

Thus, Greece has an outsized influence on global markets as we head into June. While in more “normal” times a Greek default and currency reconstruction would be absorbed in a global economy with $60 trillion in GDP, these are not normal times: in the current environment, the play-out of tragedy in Greece sends out echoes to Italy, Portugal, Spain, and elsewhere, threatening a general depression if devalued currency warfare stunts global trade, as per its potential.

The economy in the United States continues to show amazing resilience, even as equity markets traded flat last week and are down 7% since peaking in April. Indeed some of the performance metrics in the U.S. are nothing short of outstanding: retail sales are now up for 21 of the previous 22 months, during a 26-month span when 4.2 million private sector jobs have been created since the unemployment peak. Consumer spending is up 4% in real terms from a year ago, exemplified by a preferred leading indicator for us, auto sales, up 10% year-on-year to a new annual run rate of 14.3 million vehicles.

Work hours are continuing a two-year rise as well, and business (nonresidential fixed) investment, while still way off its 2006 peak and well-below long term trend, is recovering smartly as well, up 12% year-on-year.

Meanwhile data out in the past week reinforces the positive “spin” on the U.S., even in the case of declining durable goods orders mentioned above. New single-family home sales increased 3.3% in April, to a 343,000 annual rate (up nearly 10% from a year earlier), continuing a three year recovery that is on track to double from existing production levels in the next four years based on demographic needs (in contrast to Japan and most all of Europe, the United States is actually getting younger). Sales were up in the Northeast, West, and Midwest, as the supply of new homes fell to 5.1 months’ inventory from 5.2 the prior month. Further, the median price of new homes sold was $235,700 in April, up 4.9% from a year ago; the average price was $282,600, up 5.1% from 2011; this is very positive data that casts doubt on the recent gloom contained in the Case-Shiller data (all homes’ pricing is also up, by 2.7% from year-earlier levels).

Data on existing home sales matched that of new product: volumes of existing home sales rose 3.4% in April, to an annual rate of 4.62 million units; sales of these homes are also up 10.0% versus a year ago, and are up in all four regions of the U.S. including the South. Median prices for existing homes are up 10.1% from a year ago, with average prices up 7.4% in that time. New orders for durable goods were positive, too: they increased 0.2% in April, and are up 6.9% year on year (and orders excluding the volatile transport sector are still up 6.3%). While there was a severe decline in core capital goods production (viz., excluding aircraft and defense-related), the continuing rise in capacity utilization (nearing 80% for the first time in four years) and home-building should lead to a rebound in capital equipment production of all types in the months ahead.

What Reagan Faced

Considering the turmoil elsewhere, as well as the uncertainty around near term conditions here in the U.S., the continuing relative buoyancy here, and intrepid resourcefulness of American producers, is nothing short of astounding. And related to this, how heartening it was, too, to see the reprint of portions of a famous memo on economic growth strategy appearing in the Wall Street Journal this past weekend. Written to then President-Elect Reagan within two weeks of his election victory, the memo, signed by a committee including George Schultz, Milton Friedman, William E. Simon, and the incoming Chair of the Council of Economic Advisors Murray Weidenbaum, outlined the serious challenges facing the U.S. economy, and the priorities to meet them.

The committee did not mince words at a time of nearly 8% unemployment, 13% inflation, and 21% interest rates. The core concepts of a new plan, indeed, governing paradigm, for sustainable growth, included the following:

You have identified in the campaign the key issues and lines of policy necessary to restore hope and confidence in a better economic future:

• Reestablish stability in the purchasing power of the dollar.

• Achieve a widely-shared prosperity through real growth in jobs, investment, and productivity.

• Devote the resources needed for a strong defense, and accomplish the goal of releasing the creative forces of entrepreneurship, management, and labor by:

This amounts to emphasis on fundamentals for the full four years, as the key to a flourishing economy.

Reading the document in its entirety is an eerie experience because the solutions proffered mirror almost precisely what needs to happen today. The leading influence in the memo’s production, which was itself a compendium of several economic policy position papers developed during the campaign, was Milton Friedman. Professor Friedman, born 100 years ago this summer, went on to serve all eight years on President Reagan’s economic policy advisory committee, later joined by such luminaries as Thomas Sowell — it was a group Mr. Reagan described in his memoirs as enjoying immensely throughout his two terms, and a group whose 6-8 meetings per year he never missed. Indeed, in one of the understated circumstances of history, it was this group that provided encouragement to Mr. Reagan to steel his courage to “stay the course” on this 1981 Economic Recovery and Tax Act, which in the horrible economy of 1982 he was repeatedly encouraged to abandon — by his own people. In spite of electoral thrashing that November, he did exactly that, and engendered the 1983-89 seven year boom, with three million new jobs per year and a steadily declining debt-to-GDP ratio across his term.

The entire document is worth reading, but for our purposes, it is fascinating to see the items for action listed — and their priority in emphasis — as laid out by Professor Friedman. At the top of the list was restoring a sound dollar, followed by the need to promote productivity-enhancing investment. This was followed by building up the national defense in conjunction with a roll-back in spending and burdensome regulations. The Committee knew that growth in the public sector — in both taxes and spending — had led to a fiscal “crowding out” of resources available for the private sector, including defense spending. The committee advised the incoming President that his tax cuts, lessened government spending, and fewer regulations would unleash an entrepreneurial boom, and ignite the U.S. economy’s natural propensity for being the global drive-train of growth. 21 million jobs soon followed.

For those old enough to remember, it will be recalled that 1979-80 were miserable times in the U.S.: gas lines, high unemployment, stagnant real wages, increasing global trade tensions, high inflation, and an era of diminshed expectations as encouraged by the incumbent President. Mr. Reagan would have none of it, and encouraged by Milton Friedman and his confreres, applied the wisdom of Adam Smith to that era’s troubles. The resulting 25-year boom, in which the U.S. economy effectively added new growth the size of the German economy, can be re-ignited once again, and indeed could be transposed around the world to all troubled economies, including that of Greece. To do so only requires the will to implement anew the policies followed then.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.

Comments (2)

Joseph Y. Calhoun

28 May 2012 - 10:47

It is interesting in looking at the priorities in the memo that Reagan was never really able to accomplish the monetary goals. The dollar’s value rose dramatically in the first term and then fell, at the urging Treasury Secretary Baker through the Plaza Accord, in the second. So the value of the dollar never stabilized and monetary policy was not conducted in a steady manner. If anything, with the appointment of Greenspan, monetary policy was more active than ever. Reagan also wasn’t able to restrain spending in any meaningful manner. And yet, the economy performed well during Reagan’s two terms. Just goes to show that the American economy doesn’t need a lot of help to get going and stay going. Attitude and expectations play a bigger role than most people think.

My modern day version of this memo would be something like this:

1. Big picture tax reform a la 1986. Low rates, broader base, eliminate the loopholes especially in the corporate tax code. And shift some of the tax burden to consumption and away from investment.

2. Cut federal government spending: Ex-Im bank, farm subsidies, ethanol welfare, military spending, I could go on all night.

3. Monetary reform: eliminate the dual mandate and task the Fed with stabilizing the value of the dollar only. Have a serious debate about how to define the value of the dollar.

4. Financial reform: Kill Dodd-Frank and start over with simple regulations that really reduce too financial risk. Eliminate TBTF; there is no such thing. Raise the amount of required equity capital and increase it with bank size. Phase out FDIC insurance for banks that engage in anything other than plain vanilla banking but force them to acquire private insurance to cover the difference. That would provide the FDIC with a market price signal to properly price deposit insurance for large banks.

5. Do everything possible to bring competition to the primary and secondary education markets. Attach funding to individual children rather than to state or local education monopolies. Make schools compete for students. Provide additional incentives for schools to compete for special ed students.